The following item is a Letter of Intent of the government of Croatia, which describes the policies that Croatia intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Croatia, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

1. As the cornerstone of its commitment to promoting employment and raising the population's standard of living while maintaining macroeconomic stability, the Croatian government, in close collaboration with the Croatian National Bank (jointly referred to hereinafter as the Croatian authorities), has prepared a three-year economic program for the period 2001-03 that is centered on fiscal adjustment, wage discipline, and structural reforms in the context of continued exchange rate stability. To support the implementation of the program in its first year, the government of Croatia herewith requests a stand-by arrangement in an amount of SDR 200 million (54.78 percent of quota), to be made available over a 14-month period ending on April 30, 2002.

2. The implementation of our program will be monitored through quantitative performance criteria and indicative targets in the monetary, fiscal, and external sectors. In this regard, the attached Memorandum of Economic and Financial Policies (MEFP) proposes performance criteria for end-March and end-June 2001 and indicative targets for the second half of 2001. Program implementation will also be monitored through two structural performance criteria, the customary performance clauses, and two structural benchmarks, all of which are listed in Annex III and described (with the exception of the standard performance clauses) in greater detail in the following Annexes IV-X.

3. The Croatian authorities believe that the policies and measures set forth in the attached MEFP are sufficient to attain the objectives of their economic program. However, they will take any further measures that may be needed toward this end. The Croatian authorities will consult periodically with the Fund, in accordance with the Fund's policies on such consultations, about the progress being made in implementing the economic program described in the attached MEFP, and in advance of any revisions to the policies covered by the MEFP. The authorities will provide the Fund with such information as it requests on policy implementation and achievement of program objectives. In any event, during the period of the arrangement, the authorities will complete reviews with the Fund no later than August 31, 2001 and November 30, 2001, in order to (i) set the quantitative performance criteria for September 30 and December 31, 2001 (at the time of the first review) and (ii) assess progress in implementing the program and reach understandings on any additional measures that may be needed to achieve its objectives.

4. In view of Croatia's comfortable international reserves position and its easy access to international capital markets, the Croatian authorities do not intend to make the purchases under the arrangement that will become available upon approval and after observance of the performance criteria and completion of the reviews.

Sincerely yours

/s/

Slavko Linić
Deputy Prime Minister

/s/

Mato Crkvenac
Minister of Finance

/s/

Željko Rohatinski
Governor
Croatian National Bank

Attachment:
Memorandum on Economic and Financial Policies

Memorandum of Economic and Financial Policies

I. Medium-Term Economic Strategy

1. Our chief medium-term economic goal is to increase employment and
the standard of living of the Croatian population. The associated growth
of output and per capita income will promote real convergence with the
more advanced countries of Europe and bring us closer to our aspiration
of becoming a member of the European Union. We have therefore developed,
and are already implementing, an economic strategy for this government's
term in office (2000-03) that seeks to achieve sustainable high rates
of economic growth with price stability and external viability. Under
our strategy, these objectives will be pursued by a judicious combination
of fiscal adjustment, wage discipline, and structural reforms in the context
of continued exchange rate stability. Reduced government spending, wage
restraint throughout the economy as well as economic liberalization, restructuring,
and privatization will boost productivity—the basis for future real
wage increases and higher living standards—and employment. These
measures will also strengthen competitiveness, which—together with
a substantial reduction of the fiscal deficit—will bolster external
viability by reducing the external current account deficit to a level
that allows the external debt-to-GDP ratio to first decline and then stabilize
at a prudent level.

2. We believe that the policies described in Section III below will allow
the economy to accelerate its rate of growth from an expected 3½
percent in 2000 to 4 percent in 2001 and some 4½ percent in 2002-03.
Inflation is expected to moderate from 7½ percent in 2000 to 4½
percent in 2001 on an end-of-year basis, with further modest reductions
during 2002-03. At the same time, the external current account deficit
should contract from an expected 4½-4¾ percent of GDP in 2000 to just under 4 percent in 2001
and some 3¼ percent in 2003.

3. The main macroeconomic adjustments to bring about these results would
be a reduction of the deficit of the consolidated central government from
an expected 6½ percent of GDP in 2000 to some 1¼-1½
percent by 2003 and an incomes policy that would severely curtail wages
in the public sector, while encouraging the limitation of real wage increases
in the private sector to somewhat below realized annual productivity increases.
To preserve financial stability and achieve our inflation targets, monetary
policy will be conducted so as to keep the exchange rate stable.

II. Policy Implementation in 2000 and Expected Outcome

4. Upon assuming office in early 2000, the new government gave priority
to paying government arrears, which had risen to the equivalent of 6½
percent of GDP by end-1999, while reducing substantially spending on goods
and services and investment projects. To regain control over civil service
wages, which had been raised by more than 17 percent during 1999,
the government negotiated a 5 percent rollback of the basic wage in the
budgetary sphere. As a signal of its determination to establish wage discipline
throughout the economy, the government slashed the salaries of top civil
servants, members of parliament, and judges by 20 percent. In obtaining
parliamentary approval for a tough 2000 budget, the government created
room to reduce both taxes and the fiscal deficit. In particular, the government
raised the income tax threshold (to raise net wages), reduced the employer's
share of social security contributions (to lower nonwage labor costs),
lengthened the collection lag for the value-added tax (to improve enterprise
liquidity), and provided tax holidays and employment subsidies (to stimulate
investment and employment). To complete its electoral promises of tax
relief, the government obtained parliamentary approval for reductions
of the personal income and profits taxes in December 2000.

5. For its part, the Croatian National Bank (CNB) used the strengthening
external position, the repayment of government credit, and the return
of confidence in the banking system to build international reserves, ease
foreign exchange surrender requirements, allow the currency to appreciate
slightly against the euro, and reduce reserve requirements and policy
interest rates. The resulting decline in market interest rates to record
low levels has, however, only recently begun to result in an increase
in bank credit to the economy. Instead, banks have chosen to buy government
debt instruments and strengthen their net foreign position. The CNB unified
reserve requirement ratios at a lower average level in November-December,
while taking all steps necessary to absorb the excess liquidity injected
by the phased unification. The repayment of the full amount of insured
deposits in failed banks in late December has further strengthened confidence
in the banking sector.

6. The government took advantage of the changed international attitude
toward Croatia to speed up the country's integration in the world economy.
Successful negotiations led to the completion of WTO membership in November,
while trade concessions were obtained from the EU, with which negotiations
on a Stabilization and Association Agreement were initiated in November.
A free trade agreement with Bosnia and Herzegovina has recently been signed
and is being implemented. Other free trade agreements are currently under
negotiation.

7. We now estimate economic growth to have reached 3.5 percent in
2000. A rebound of private consumption and strong growth of both merchandise
and tourism exports more than account for the economic recovery, while
investment and government consumption have continued to contract. Following
excise tax and energy price increases, the 12-month rate of inflation
rose to almost 7½ percent in December. However, core inflation remained
at around 4½ percent, holding out the prospect for a lower rate of
inflation in 2001. Notwithstanding higher oil prices, other exogenous
factors, such as the improved regional security situation and improved
access to foreign markets, and fiscal adjustment are expected to have
narrowed the external current account deficit to a little more than 4½
percent of GDP in 2000.

III. The Economic Program for 2001

8. The recently approved three-year budget outlook and a yet to be negotiated
social pact provide the medium-term framework for our economic program
for 2001. Our 2001 program is rounded out by a monetary program that aims
at reducing inflation on the basis of exchange rate stability and by an
acceleration of structural reforms.

A. Objectives

9. Our program assumes a further small acceleration of economic growth
to 4 percent in 2001. The acceleration is expected to stem from domestic
demand. Notwithstanding greater wage restraint, disposable income will
be boosted in 2001 by income tax reduction and higher pension payments.
On balance, the growth of private consumption is likely to slow somewhat
after the vigorous rebound in 2000. The payment of insured deposits in
failed banks may also lead to higher consumption in early 2001. Private
investment, which has been almost flat in 2000, is likely to respond to
improved profitability (due to lower nonwage labor costs, wage restraint,
lower energy prices, and continued expansion of final demand), progress
in structural reform and fiscal consolidation, and the availability of
financing from a liquid banking sector at low interest rates. However,
continued fiscal adjustment implies that government spending will once
more exert a restraining influence on output growth. While the jump of
export volume in 2000 is unlikely to be repeated, the improved security
situation, better access to foreign markets, and continued expansion of
demand in our major trading partners should allow the growth of exports
to exceed that of import volume once more.

10. Notwithstanding the rise of headline inflation due to the supply
shocks experienced in 2000, we believe that the inflation outlook is benign.
Core inflation remains at a 4½ percent annual rate and the prospect
of lower oil prices, greater wage restraint, further reductions of import
duties, and a stable exchange rate should allow headline inflation to
decline from almost 7½ percent to 4½ percent during 2001. This
process will be helped by the disappearance of base year effects from
tax and corrective price increases after midyear.

11. While our economic program calls for a further modest increase in
net international reserves of the CNB that would maintain the reserve
cover of imports of goods and nonfactor services at about 4¼ months,
our principal external objective is the continued reduction of the current
account deficit to a level that ensures external viability. We therefore
aim to reduce the current account deficit further by about ¾ of a
percentage point of GDP in 2001. The likely large inflow of privatization
receipts would permit the partial reversal of last year's large increase
in the external debt to GDP ratio. With privatization receipts dwindling
after 2002, however, a pickup of greenfield investment and/or further
current account adjustment would be needed to continue lowering the debt
ratio. We believe that the favorable effects from the improved security
situation and better access to foreign markets represent a permanent exogenous
shift that has improved our underlying current account situation. The
recent oil price decline should also help in 2001. Nonetheless, we realize
the need for domestic policy adjustments to underpin the achievement of
our current account target in 2001 and beyond. As we have decided to rely
on a stable currency as a pillar of macroeconomic stability, our economic
program relies on fiscal adjustment, wage restraint, and structural reforms
to improve the current account.

B. Fiscal Policy

12. The centerpiece of our economic program for 2001 is continued fiscal
adjustment. The government intends to further reduce the deficit of the
consolidated central government from an expected 6½ percent of GDP
in 2000 to 5¼ percent in 2001. As the full-year effect of recent
revenue reductions and new measures to reduce the personal income and
profits taxes will lower the revenue ratio in 2001, the expenditure ratio
will fall even more rapidly, from an expected 46 percent of GDP in
2000 to 43 percent in 2001. In accordance with the government's three-year
budget framework, the measures introduced under our 2001 program provide
a sound basis for further reductions of the deficit to about 4¼ percent
of GDP in 2002 and about 1¼ percent of GDP in 2003 and of the expenditure
ratio to about 41 percent of GDP in 2002 and about 37½ percent of
GDP in 2003.1

13. Our revenue estimates for 2001 include the following changes to the
tax system. The personal income tax has been reduced for low-income earners,
and dividend income has been subjected to the lowest income tax rate (15 percent).
The profits tax rate has been lowered, certain deductions have been introduced
or increased, and the exemption of part of invested capital from taxation
has been abolished. The excise tax on cars has been raised by broadening
its base and the VAT exemption for the purchase of imported cars by war
veterans will soon be repealed. The excise tax on gasoline and diesel
will be increased by HRK 0.3 per liter when the responsibility for road
maintenance and construction is transferred to a separate agency at the
end of March 2001. Additional excise tax changes will be implemented in
early 2001 to produce a revenue increase equivalent to 0.2 percent
of GDP. Apart from internationally agreed import tariff reductions, the
government does not intend to introduce any other tax or social security
contribution changes during the program period. In particular, it will
not reduce the VAT rate of 22 percent, nor will it allow further zero
ratings or exemptions from VAT.

14. As the above-mentioned tax policy changes will reduce the revenue-to-GDP
ratio, attainment of our fiscal deficit target for 2001 hinges crucially
on a reduction of the expenditure ratio by some 3 percentage points
of GDP. As the embedded table indicates, all major expenditure categories
will be reduced in nominal terms except for interest payments and subsidies
and other current transfers, which will increase primarily because of
last year's increase in government debt and the start of payments to compensate
pensioners for past inadequate indexation of pensions, respectively. The
reduction in wage payments of the consolidated central government includes
a 10 percent cut in the wage bill of the state budget to a level
that will be maintained in nominal terms in 2002-2003. The underlying
wage policy and employment measures are described more fully in Section III.C
and Annex IX. The expenditure cuts also result from the transfer of expenditure
responsibility for roads to a separate agency at end-March 2001 and from
health care reform and the devolution of some social spending to local
governments at mid-year.2

Croatia: Consolidated Central Government
Expenditures, 2000-01

Proj.
2000

Prog.
2001

Change

Proj.
2000

Prog.
2001

Change

(In millions of Hrk)

(In percent)

(In percent of GDP)

Expenditure and net lending

72,486

73,839

1.9

46.2

43.1

-3.1

Expenditure

71,641

73,009

1.9

45.7

42.6

-3.1

Current expenditure

65,806

67,429

2.5

42.0

39.4

-2.6

Wages and employer contributions

17,994

16,517

-8.2

11.5

9.6

1.8

Other purchases of goods and services

15,325

14,059

-8.3

9.8

8.2

-1.6

Interest payments

2,943

3,595

22.1

1.9

2.1

0.2

Subsidies and other current transfers

29,543

33,258

12.6

18.8

19.4

0.6

Capital expenditure

5,835

5,580

-4.4

3.7

3.3

-0.5

Lending minus repayments

845

830

-1.7

0.5

0.5

-0.1

15. The above-specified measures are judged sufficient to ensure that
the deficit of the consolidated central government will not exceed 5.3 percent
of GDP in 2001. As a prudential measure, however, we will defer budgeted
expenditure equivalent to ½ percent of GDP to the second half
of 2001. These funds will only be released if a midyear review of the
implementation of our program shows that the external current account
deficit is on track to decline to just below 4 percent of GDP in
2001. We do not intend to establish any new extrabudgetary funds during
the program period. The fiscal deficit is financed almost entirely by
privatization receipts. Net foreign borrowing of 1.0 percent of GDP would
finance the remainder of the deficit while allowing the reduction of arrears
accumulated by the government and the health fund in 2000 by 0.9 percent
of GDP without any recourse to domestic bank borrowing. Observance of
the overall fiscal deficit target and the limits on net borrowing from
the domestic banking system and the level of arrears of the consolidated
central government have been made performance criteria under the requested
arrangement (Annex IV). Likewise, the maximum
amount of short-term external credit to the government and the contracting
and guaranteeing of nonconcessional external debt with a maturity of more
than one year are performance criteria under the requested arrangement
(Annex VI).

16. To compensate for any slippage, in particular in the implementation
of its wage policy outlined in paragraph 18, the government is prepared
to implement contingency measures to ensure that its fiscal deficit target
will be attained. Such measures, some of which are under consideration
on their own merits to meet our fiscal objectives for 2002-03, include
the following: increased copayments for health services and medicines;
harmonizing the income tax treatment of pensioners with that for other
tax payers; reintroduction of health insurance contributions on large
pensions; annual (instead of biannual) indexation of pensions; reduction
of veterans' pensions and harmonizing their indexation with that for other
pensions; and an increase in the excise tax on gasoline and diesel by
HRK 0.3 per liter.

C. Incomes Policy

17. Wage restraint throughout the economy is a key plank of our program:
it is important to strengthen competitiveness and improve the external
current account, and it is needed to stimulate exports, investment, employment,
and growth. For this reason, the government, in cooperation with the social
partners, will implement a three-pronged incomes policy in 2001 and the
period through 2003.

18. To achieve the 10 percent reduction of the wage bill envisaged in
the 2001 state budget and make it sustainable in 2002-03, the government
will implement measures, more fully described in Annex
IX, that will progressively lower wage outlays during 2001. The basic
monthly wage will remain frozen at HRK 1,425 and employment will be reduced
by 10,000 (or 5½percent) during the year.3
Two new laws on public administration and on civil service employment,
to be enacted by end-February 2001, will replace the present system of
wage categories for individual ministries with a uniform range of coefficients,
which the government will set by decree for individual positions. This
will lead to a net reduction of some 6-7 percent in the wage bill.
The new laws will also reduce the length and amount of severance payments,
while eliminating the need to pay supplements and allowances for those
to be laid off. Overtime pay, accounting for 2 percent of the wage bill,
will be replaced by additional leave. Finally, no vacation bonuses, Christmas
bonuses, or children's benefits will be paid in 2001, and an income test
will be applied to the transportation allowance, with an expected annual
savings of 0.3 percent of GDP. Outside the budget sphere (mainly in the
health sector with its 65,000 employees) the government intends to negotiate
a wage freeze.

19. We intend to keep average wages (excluding Christmas, vacation, and
child bonuses) in the fully or majority state-owned enterprises (the public
enterprises) at their 2000 level during 2001. The bonuses, which were
mandatory until now, will be made voluntary and only profitable enterprises
that do not rely on government guarantees or subsidies will be allowed
to pay bonuses in 2001. In the 10 largest public enterprises, we have
instructed managements and supervisory boards to implement this policy
and to submit plans to cut employment of administrative staff by 10 percent
in 2001.4 Managerial
contracts in those companies can henceforth only be concluded with management
board members and their salaries will not be permitted to exceed those
of government officials (e.g., the chairman of the board cannot receive
a higher salary than a government minister). These policies will be strictly
monitored in the 10 largest public enterprises, but they are also binding
for other public enterprises. We expect that these measures will not only
improve the financial situation of these enterprises and encourage workers
to leave the generally overstaffed public enterprise sector, but that
it will also help overcome the resistance of workers to privatization.

20. The government's wage policy for the public sector covers almost
half of total employment in the formal sector of the economy. For the
remainder (including all public enterprises privatized during the next
three years and enterprises with minority public participation) we will
present shortly a proposal for discussions with unions and employers on
a three-year social pact that would establish guidelines for the negotiation
of collective wage agreements at the branch and enterprise levels. Our
objective is to agree on guidelines that would keep real wage increases
somewhat (perhaps by 1-2 percentage points) below realized annual productivity
gains. Similarly, we would aim to base cost of living adjustments on the
expected increase in the retail price index in the 12 months ahead (i.e.,
4½ percent for calendar year 2001), with a catch-up provision if
inflation exceeds the forecast rate by a specified threshold. Exogenous
price shocks, such as oil price or indirect tax increases, would be excluded
from the cost of living adjustment.

21. We expect the above described wage policy to result in a shift of
employment from the public to the private sector and in a substantial
increase in overall employment after 2001. As many of the laid off workers
will not yet be eligible for pensions, we intend to implement active labor
market policies, with financial support from the World Bank's SAL (currently
under negotiation) to retrain them. Given its importance for the successful
implementation of our program, the above described public sector wage
policy will provide two structural performance criteria under the requested
arrangement (Annex IX). Implementation of the
entire wage policy will be monitored by observance of the quarterly budgetary
wage ceilings, and progress in this area will be an important issue for
the completion of the two reviews envisaged under the requested arrangement.

D. Monetary and Exchange Rate Policy

22. The government's fiscal and incomes policies will greatly facilitate
the CNB's task of pursuing price stability over the next three years.
As the preconditions for successful inflation targeting are not yet fulfilled
in Croatia, we believe that the present program's inflation objective
is best served by the stability of the kuna's exchange rate against the
euro. Accordingly, the CNB will continue to attach great importance to
the stability of that rate. We believe that—apart from the usual
seasonal fluctuation of the exchange rate—the CNB's monetary program
for 2001, described in paragraph 23, is compatible with exchange
rate stability. However, the CNB will use monetary policy as needed to
stabilize the kuna against the euro. In such an environment, interest
rates are expected to align themselves more closely with those in the
euro area. This does, however, not preclude temporary departures of domestic
short-term rates from those prevailing abroad as the CNB intervenes in
pursuit of its price stability mandate to influence domestic liquidity
conditions.

23. The CNB's monetary program for 2001 aims at reducing inflation to
4½ percent by year-end. Economic growth and a further strengthening
of confidence are expected to attract sufficient financial resources to
allow credit to the nongovernment sector to grow by 16 percent. Any
remaining liquidity needs of the business sector are likely to be met
by self-financing out of rising profits, the payment of remaining government
and health fund arrears, and access to foreign borrowing in the case of
the larger enterprises. The government would not need any bank financing
during 2001. On the contrary, its front-loaded foreign borrowing and privatization
plans would allow it to temporarily reduce its bank debt in the first
half of 2001. The CNB will use part of the rising demand for base money
during the tourism season to accumulate international reserves in an effort
to keep their gross level at about 4¼ months of imports of goods
and nonfactor services at year-end. The international reserve targets
will be a performance criterion under the requested arrangement (Annex
VII). In an effort to rely more on market-oriented instruments, the
CNB plans to further reduce the unified reserve requirement ratio, market
conditions permitting. In accordance with the new CNB law, there will
be no more CNB credit to the government. Accordingly, the excess of base
money demand over reserve accumulation will be at the disposal of the
commercial banks. In pursuit of its inflation objective, however, the
CNB will conduct open market operations to absorb any buildup of excess
liquidity. To guide it in implementing monetary policy during 2001, the
CNB has established limits on the change of its net domestic assets. These
limits will be a performance criterion under the requested arrangement
(Annex VIII). Should base money demand be weaker
than assumed in the CNB's program, the CNB will tighten credit sufficiently
to ensure that its international reserve targets are observed. If, however,
base money demand turns out to be stronger than assumed, the CNB will
consult with the Fund to determine if the inflation outlook justifies
easing the limits on net domestic assets. To ensure that the envisaged
room for credit expansion to the nongovernment sector is not pre-empted
by public enterprise borrowing, we have established limits on net domestic
bank borrowing by 10 large public enterprises. These limits will be a
performance criterion under the requested arrangement (Annex V).

E. Structural Reforms

24. Our macroeconomic program for 2001 and beyond relies on the realization
of a large number of structural reforms, most of which will be prepared
and implemented with the assistance of the World Bank and regional and
bilateral development institutions. The attached matrix (Annex
I) lists the most important of these reforms and the timelines for
their expected implementation. Here, we describe briefly those reforms
most relevant to macroeconomic adjustment, with particular emphasis on
the ones to be implemented with the assistance of, and/or monitored by,
the IMF.

Fiscal sector reforms

25. From the start of 2001 a new treasury system has begun operations
in the Ministry of Finance. All central budget expenditure (excluding
initially the extrabudgetary funds) will henceforth be authorized and
certified by the treasury. All but routine items are now immediately paid
by a new treasury single account. Starting on July 1, 2001, routine budget
items and expenditure of all extrabudgetary funds except the health fund
will also be channeled through the treasury and its single account and
all separate ministerial accounts will be closed. Health fund expenditure
will follow by January 1, 2002, after implementation of health care reform.
These changes will enable us for the first time to prevent the buildup
of government arrears and to monitor the reduction and eventual elimination
of existing arrears. The 2002 budgets of the central government and the
extrabudgetary funds, which will be presented jointly to parliament on
a uniform classification basis, will draw on the recommendations of an
ongoing public expenditure review conducted by the World Bank. Following
the adoption of stricter criteria for the extension of government guarantees,
the government will develop and apply by mid-2001 a monitoring system
for government guarantees and for the contracting of lease agreements.
The Ministry of Agriculture will compile a list of farmers in time for
the 2002 budget so as to facilitate the changeover from price-support
to income-support subsidies.

26. Apart from the measures mentioned in Section III.B, the finances
of the pension system are being strengthened by the phased implementation
of the first-pillar reform of 1999, notably the gradual extension of the
period for calculating the pensionable base from the 10 years with
the highest income to lifetime earnings and the gradual increase in the
statutory retirement age from 60 to 65 years for men and from 55 to 60
years for women. We are now examining further measures to strengthen the
pay-as-you-go pillar, for example, by equalizing the statutory retirement
ages of men and women at 65 years and adjusting replacement rates to take
account of rising life expectancies of pensioners. If required by the
continued adverse population dynamics, we may eventually have to resort
to indexing pensions (and perhaps even pensionable bases) to prices rather
than the average of prices and wages. With the recent startup of the central
registry of affiliates and the regulatory authority for private pension
funds, we can proceed with the introduction of the three-pillar system.
By mid-2001, we expect the voluntary third pillar to start operations.
And we will implement the mandatory second pillar with effect from January
1, 2002. An estimate of the transition cost of introducing the second
pillar is included in our fiscal framework for 2002 and 2003.

27. As noted in Section III.B, the responsibility for maintenance
and investment spending for primary health care facilities will be transferred
in mid-2001 to the lower levels of government. Measures not yet taken
into account in our fiscal projections include the increase in copayments
for drugs and selected medical treatments and services and the reduction
of widespread exemptions from such payments, and the introduction of performance-based
reimbursements for doctors and hospitals in line with the new clinical
guidelines. Private insurance for copayments and treatments not covered
by the basic package that will be introduced in 2001 will be encouraged.

28. In proceeding with decentralization, the central government will
provide the lower levels of government with adequate tax bases of their
own while trying to retain as much of shared taxes as possible to reduce
its own fiscal deficit. We will examine with the lower levels of government
how the reporting lags with respect to their operations can be shortened
sufficiently to allow future monitoring of fiscal trends at the general
government level.

Monetary and financial sector reforms

29. In the monetary area, further steps to reduce reserve requirements,
as referred to in Section III.D, will be taken. We will ensure that differential
rates of remuneration on required reserves will not bias the choice between
domestic and foreign currency deposits. By March 2001 we will amend the
foreign exchange law to allow legal entities to open foreign exchange
accounts with Croatian banks for any purpose and to allow domestic banks
to extend foreign exchange denominated credit to residents without any
restrictions. As a medium-term objective, we subscribe to further capital
account liberalization, but it would have to be gradually phased in only
after financial sector soundness has been firmly established.

30. We encourage the further consolidation of the domestic banking sector
and actively seek to privatize two of the remaining three government-owned
banks. Privatization plans for Dubrovačka Banka and Croatia Banka
have been prepared by the bank rehabilitation agency. The banks will now
be prepared for privatization, and tenders for their sale will be conducted
by end-March 2001 and end-September 2001, respectively. The other government-owned
bank, Hrvatska Po_tanska Banka (HPB), is likely to need recapitalization
and the government is examining ways to improve its performance, including
the possibility of privatization, while preserving its special payment
service function through its vast branch network. If needed, privatization
receipts of the privatization fund will be used to recapitalize HPB. The
Croatian Insurance company, which still controls more than 50 percent
of the domestic market, will also be privatized in the course of 2001.

31. We expect the new CNB law to be approved by parliament by March 2001.
We will now prepare a new banking law that will provide the CNB with an
automatic graduated response to banks not in compliance with regulations
and ensure prompt bank resolution on the basis of the least-cost principle.
The law will also clarify and strengthen the procedures pertaining to
the insolvency of banks. We expect the new law to be adopted by parliament
by December 2001. In the meantime, the CNB is applying the existing law
with an eye to limiting discretion in its implementation so as to ensure
gradual full compliance of banking operations with all regulations and
limitations envisaged in the law. The CNB is also strengthening the framework
for resolving any future banking problems.

32. Finally, we are undertaking a number of steps to improve the functioning
of the money and capital markets and the payments and settlement systems
and to strengthen the regulation and supervision of nonbanks. In all instances,
legislative changes will be designed to achieve harmonization with EU
standards.

Public enterprise reform and privatization

33. The government wants to divest most public enterprises while keeping
a minority share in only some of them. Three hundred and twenty-one insolvent
companies that employed some 11,000 people have recently been put into
bankruptcy and are being liquidated. The government has recently reached
agreements with the shipyards and the railway company (HZ) on restructuring
measures and the amount of subsidization to be provided by the budget.
The shipyards and as much as possible of HZ will be privatized. The privatization
fund (CPF), which manages the government's share in a large number of
companies on its own behalf and on behalf of the pension fund and the
bank rehabilitation agency, will aim to sell 327 companies of its
pooled portfolio by end-2001. These companies account for almost two thirds
of the 88,000 people employed in the 520 companies managed by the CPF
in which the government has a share of more than 25 percent. We now
expect the IPO for at least 20 percent of shares of the telecommunications
company (HT) to be completed by mid-2001. Bringing it to the point of
completion for both domestic and international sale is a structural benchmark
under the requested arrangement (Annex X).
A new telecommunications law will be submitted to parliament soon to regulate
the market and to ensure fair pricing until HT's fixed-line monopoly expires
in 2003.

34. Energy sector reform and privatization are being prepared in close
cooperation with the World Bank. A package of five laws will be sent to
parliament by end-February 2001 to regulate the energy market and restructure
the electricity (HEP) and oil and gas (INA) companies. Following the establishment
of a regulatory agency, INA will be restructured and split into an oil
and gas production company and a gas transportation company and HEP's
operations will be unbundled into three commercially separate power generation,
transmission, and distribution companies. The INA and HEP groups will
spin off noncore functions and prepare their constituent companies for
privatization on the basis of two laws, which are expected to be adopted
by parliament by September 2001 (a structural benchmark). Privatization
of the constituent companies could then proceed in 2002. The JANAF oil
and gas pipeline is expected to be privatized in late 2001, as may be
some parts of HEP and INA if needed to achieve this year's budget target
for privatization revenue.

Trade policy and other reforms

35. Following WTO accession and the start of negotiations with the EU
on a Stabilization and Association Agreement in late 2000, the government
has intensified the negotiation of bilateral free trade agreements with
the EU, EFTA, and 13 bilateral trade partners. With the successful completion
of these negotiations by March 2001, the government expects to have almost
80 percent of its foreign trade covered by free trade agreements. Under
our program, we will not introduce or intensify restrictions on payments
and transfers for current international transactions, multiple currency
practices, or import restrictions for balance of payments purposes, nor
will we tolerate the accumulation of external arrears.

36. With World Bank assistance, we are beginning to take measures to
strengthen the capacity of our commercial courts to resolve bankruptcy
cases.

I. Limits on the Cumulative Deficit of theConsolidated Central Government

Ceilings

(In millions of kuna)

Cumulative Changes from December 31, 2000:

March 31, 2001
June 30, 2001
September 30, 2001 1
December 31, 2001 1

3,500
3,850
6,300
9,100

1 Indicative
limit.

The above listed ceilings on the cumulative deficit of the consolidated
central government cover: (i) central government operations, that is,
the central government budget (the Office of the President, the parliament,
the government, the constitutional court, all ministries, other independent
state administration and judicial bodies); (ii) existing central extrabudgetary
funds (health, pension, employment, child benefit, and water management
funds); and (iii) the proposed Fund of Assets for Investment Promotion
and Fund for the Creation of New Jobs and Re-training. The government
will not establish new extrabudgetary funds during the program period,
but any such funds would be covered by the ceilings.

The ceilings do not include the net borrowing of the Croatian Bank for
Reconstruction and Development (HBOR). HBOR's net borrowing in 2001—defined
as the change in gross liabilities minus the change in total loans—is
projected to be HRK 800 million and will be monitored under the program.
There will be no new borrowing by the Deposit Insurance and Bank Rehabilitation
Agency (BRA) or by the Croatian Privatization Fund (CPF). At any rate,
their borrowing would be excluded from the ceilings. This will also be
monitored under the program.

For purposes of the program, the deficit will be defined on a cash-adjusted
basis (i.e., on a cash basis adjusted by the net change in arrears). The
cost for recapitalizing banks will be considered as "above the line."
The following will be considered as "below the line": privatization
receipts, payment of arrears, payment of promissory notes issued by the
Ministry of Finance and the Health Fund, payment of insured deposits,
bonds issued for financing the recapitalization of banks, redemption of
government bonds tendered by the CNB in connection with bank resolution,
and any release of foreign-held blocked foreign assets of the former SFRY
to the government.

The limit on the deficit of the consolidated central government will
be adjusted downward to offset the net effect of any reduction in interest
payments attributable to rescheduling of existing government debt.

The quarterly limits will be monitored from below the line on the basis
of data provided monthly by the Ministry of Finance and the CNB within
30 days. Net borrowing by HBOR and new borrowing by BRA and CPF will be
reported quarterly by the CNB within 30 days.

II. Limits on the Cumulative
Increases in the Net Creditof the Banking System to the Consolidated Central Government

Ceilings

(In millions of kuna)

Stock as of December 31, 2000 1

12,210

Cumulative changes from December 31, 2000:
March 31, 2001
June 30, 2001
September 30, 2001 2
December 31, 2001 2

-1,550
-2,300
-250
—

1 This stock
of claims consists mainly of the counterpart to frozen foreign exchange
deposits and "big bonds," which are restructuring bonds
issued in 1991 and 1992, and held by banks in lieu of claims on
enterprises; the total stock of claims as of December 31, 2000 also
includes the bonds issued to finance the payout of insured deposits
in failed banks.2 Indicative limit.

The quarterly limits are cumulative. The consolidated central government
is as defined in Section I above.

For program purposes, net credit of the banking system to the consolidated
central government is defined as all claims of the banking system on the
consolidated central government less all deposits of the consolidated
central government with the banking system.

Data on banking system claims on and liabilities to the consolidated
central government are taken from the balance sheets of the banks and
the CNB, and will be provided monthly to the Fund by the CNB within 30
days. All currency conversions will be done using December 30, 2000
exchange rates (in HrK per unit of foreign currency) as follows:

Euro:

7.598334

Swiss franc:

4.989712

Japanese yen (100):

7.103902

U.S. dollar:

8.155344

Pound sterling:

12.176817

III. Limits on the Arrears of theConsolidated Central Government

Ceilings

(In millions of kuna)

Stock as of December 31, 2000:

3,279

Cumulative changes from December 31, 2000:
March 31, 2001
June 30, 2001
September 30, 2001 1
December 31, 2001 1

—
-1,500
-1,500
-1,500

1 Indicative
limit.

Arrears include all overdue payments by more than 90 days and any promissory
notes issued by the Ministry of Finance and the central extrabudgetary
funds. The stock of arrears will be provided monthly to the Fund by the
Ministry of Finance within 30 days.

Annex V

Limits on the Cumulative Increases in the Net Credit
of theBanking System to Selected Public Enterprises

Ceilings

(In millions of kuna)

Stock as of December 31, 2000
Cumulative changes from December 31, 2000:
March 31, 2001
June 30, 2001
September 30, 2001 1
December 31, 2001 1

1,003

600
600
600
700

1 Indicative limit.

These aggregate limits cover the 10 enterprises listed below. Net credit
is defined as the sum of all short-term and long-term bank claims in local
and foreign currency on these enterprises by banks resident in Croatia
plus the amount of credit guaranteed by Croatian banks from domestic nonbank
and foreign sources, less the sum of these enterprises' total deposits
in local and foreign currency with such banks. Credit guaranteed by the
government or resulting from the calling of performance guarantees will
be excluded from the ceilings to the extent that it is not already reflected
in the balance sheets of the banks.

Enterprises on the above list that are privatized in the course of the
arrangement will be removed from the limits and the limits will be adjusted
downward by the amount of the net credit outstanding to those enterprises
at the end of the month preceding privatization. Whenever changes in accounting
practices or the set of enterprises reporting to the CNB result in changes
in the data series, the Fund will be notified and provided one-quarter
of data calculated with both the old and new definitions and an offsetting
adjustment will be made to the limits. The limits will be adjusted downward
by the amount of any bank or enterprise rehabilitation that writes off
or removes these assets and liabilities from the banking system or any
debt-equity swaps that convert bank debt into equity in the enterprises.
Information regarding such debt-equity swaps will be provided by the Ministry
of Economy if and when they occur.

The above maximum changes will be cumulative and will be monitored on
the basis of December 30, 2000 exchange rates (as listed in Annex
IV.II) from data collected monthly by the Ministry of Finance (ORESE)
and supplied to the Fund within 30 days.

Annex VI

Ceilings on the Stock of Short-Term External Public
and Publicly Guaranteed Debt and on Contracting or Guaranteeing of Nonconcessional External Debt by the Public Sector

Ceilings

(In millions of U.S. dollars)

Ceilings

Ceilings

Subceilings

=1
year

>1 year

<5 years

Stock as of December 31, 2000

509

5,908

508

Cumulative changes from December 31, 2000:

March 31, 2001
June 30, 2001
September 30, 2001 1
December 31, 2001 1

500
100
100
100

1,250
1,300
1,400
1,525

250
250
250
250

1
Indicative limits.

For program purposes, the term "debt" will be used as defined
in No. 9 of the revised Guidelines on Performance Criteria with Respect
to External Debt or Borrowing in the Fund Arrangements (Executive Board
Decision No. 6230-(79/140), as amended by Executive Board Decision No.
11096-(95/100) adopted on October 25, 1995). However, for the time being
lease contracts will not be covered by the ceilings. A reporting system
for lease contracts is currently being set up by the Ministry of Finance.
Once functional, leases will be included in the debt contracting ceilings.

The short-term debt limits do not apply to normal import-related credits.

The ceilings on medium- and long-term debt apply to the contracting or
guaranteeing of new nonconcessional external debt with an original maturity
of more than one year, and, within this limit, with an original maturity
of more than one year and less than 5 years. Concessional loans are defined
as those with a grant element of 35 percent, using currency-specific discount
rates based on the six-month average commercial interest rates reported
by the OECD (CIRRs) for loans with maturities of less than 15 years, and
on the 10-year average CIRRS for loans with maturities of 15 years and
more.

The public sector comprises the consolidated central government as defined
in Annex IV, the CNB, BRA, HBOR, CPF, the 10 large
public enterprises listed in Annex V, and the lower
levels of government. Excluded from the limits are performance guarantees
on the construction of ships (for no more than the value of advance payments),
and changes in indebtedness resulting from refinancing and rescheduling,
including the capitalization of interest in arrears.

The above limits also do not apply to guarantees by the central government
for suppliers' credits related to imports for constructing ships during
the period until delivery of the ships takes place. In case of orders
for multiple ships, the import related credits could take the form of
revolving external credit lines. To monitor such guarantees, data on the
guarantees extended for ship building, including performance guarantees
or bonds, and the payments and deliveries for ships built with these guarantees
will be supplied on a quarterly basis.

Debt falling within the limits shall be valued in U.S. dollars at the
exchange rates prevailing at the time when the debt is contracted.

Information on the contracting and guaranteeing of new debt falling both
inside and outside the limits will be reported monthly to the Fund within
30 days by the CNB.

Annex VII

Targets for Cumulative Increases in the Net UsableInternational Reserves of the Croatian National Bank

Floors

(In millions of U.S. dollars)

Stock as of December 31, 2000

2,328

Cumulative changes from December 31, 2000:
March 31, 2001
June 30, 2001
September 30, 2001 1
December 31, 2001 1

-125
-12
654
271

1 Indicative
floor.

For purposes of the program, net usable international reserves of the
Croatian National Bank (CNB) are defined as the U.S. dollar value of gross
foreign assets minus reserve assets held against foreign currency deposits
by domestic banks and against CNB foreign exchange bills minus gross foreign
liabilities minus off-balance sheet foreign currency obligations.

For purposes of the program, gross foreign assets shall be defined as
monetary gold, holdings of SDRs, any reserve position in the IMF, and
holdings of foreign exchange in convertible currencies by the CNB (the
accounting values of exchange rates and SDRs are specifically defined
below for program purposes). Any return to the CNB of blocked foreign
assets that are not part of CNB foreign assets as of December 31, 2000
will be added to the reserve floor. Reserves that are pledged, frozen,
or used as collateral shall be excluded from the gross foreign assets.
In particular, any reserve assets pledged to secure government debt will
be excluded from the reserves definition.

For purposes of the program, reserve liabilities shall be defined as
all liabilities of the CNB to nonresidents—excluding deposits into
the special accounts for external debt servicing—with an original
maturity of up to and including one year, as well as liabilities arising
from IMF purchases and bridge loans from the BIS, irrespective of their
maturity. For purposes of the program, reserve liabilities shall also
include guarantees provided by the CNB backed by reserves as collateral.

The net forward position of the CNB is defined as the difference between
the face value of foreign currency-denominated CNB off-balance sheet claims
on nonresidents (forwards, swaps, options, and futures market contracts)
and foreign currency obligations to both residents and nonresidents. This
position amounted to US$0 million on December 31, 2000. For program purposes,
only the off-balance sheet obligations will be deducted from the CNB's
net international reserves position. These liabilities amounted to US$0
million on December 31, 2000.

The net international reserves target for June 30, 2001 will be lowered
by US$121 million, if the envisaged privatization of the telecommunications
company (HT) is delayed beyond the second quarter.

For program purposes, the accounting exchange rates are equal to the
mid-points of the exchange rates obtaining on December14, 2000. For the
five most important currencies and the SDR, these exchange rates were
(in kuna per unit of foreign currency):

Euro:

7.591856

Swiss franc:

5.051135

Japanese yen:

7.708251 (100 yen)

U.S. dollar:

8.667492

Pound sterling:

12.538160

SDR:

11.175344

The limits will be monitored from data on the accounts of the CNB supplied
monthly to the Fund by the CNB within 15 days.

Annex VIII

Limits on the Cumulative Increases in the Net DomesticAssets of the Croatian National Bank

Ceilings

(In millions of kuna)

Stock as of December 31, 2000

-8,461

Cumulative changes from December 31, 2000:
March 31, 2001
June 30, 2001
September 30, 2001 1
December 31, 2001 1

197
37
-5,198
-1,470

1 Indicative
limit.

The net domestic assets of the Croatian National Bank (CNB) are defined
as the difference between the base money and the net usable international
reserves of the CNB (as defined for program purposes in Annex
VII), both expressed in local currency at program exchange rates.
Base money is defined as currency outside banks, vault cash of banks,
giro and required reserve deposits of banks in domestic currency, and
deposit money held at the CNB.

The limit for June 30, 2001 will be raised by the equivalent of US$121
million if the envisaged privatization of the telecommunications company
(HT) is delayed beyond the second quarter.

If base money demand exceeds its projection, the CNB will consult with
the Fund to determine whether these limits can be adjusted without jeopardizing
the authorities' inflation target. The projected stocks of base money
are as follows.

Projection

(In millions of kuna)

March 31, 2001
June 30, 2001
September 30, 2001
December 31, 2001

10,830
11,650
12,187
12,596

The limits will be monitored from data on the accounts of the CNB supplied
monthly to the Fund by the CNB within 15 days.

Annex IX

Implementation of a Restrained Wage Policy

(Number of Affected Employees in Parentheses)

1. Budgetary sector (182,000)

The state budget envisages a 10 percent cut in the wage bill for
2001, under the following quarterly wage bill ceilings for the central
government (in HRK million):

Quarter I

Quarter II

Quarter III

Quarter IV

3,715

3,523

3,345

3,125

Any excess in the cumulative wage bill will trigger compensatory
measures as outlined in paragraph 16 of the MEFP.

Before end-2000

Finalize government strategy to effect the 10 percent wage bill
cut in 2001, as mandated by Article 53 of the 2001 Budget Execution
Law.1

Announce that in 2001 the basic wage for the public administration
and public service shall be retained at the same level as in 2000.
1

Decree that wages of higher public officials shall, in 2001,
be at the same level as in 2000.1

Announce that no vacation bonuses, Christmas bonuses, or children's
benefits (in cash or kind) shall be paid in the public administration
and public service in 2001.1

Announce that the government shall pass a decree on the value
of coefficients for individual posts within new ranges to be established
by the forthcoming Laws on Public Administration and Civil Service
Employment, such that any wage supplements heretofore granted
by the decisions of line ministries will be terminated upon approval
of these Laws. In anticipation of such supplements being abolished,
travel allowances granted at the end of 2000 will be for a period
of one month, rather than one year as has been customary at end-year.1

On January 15, 2001
Submit to parliament draft Laws on Public Administration and Civil
Service Employment to rationalize the salary structure with a view
to achieving a net reduction in wages and to introduce a 6-12-month
severance period (with 90 percent pay) instead of placing people on
leave for 12-36 months (with full pay) prior to dismissal.

By February 28, 2001
Enact the Laws on Public Administration and Civil Service Employment.1

By March 31, 2001.

Enact a government decree on establishing a uniform set of salary
coefficients for individual posts across government ministries,
to replace the current system of ministry-specific assignment
of coefficients to similar posts, and with a view to reducing
the wage bill.2

Issue separate decrees determining each Ministry's wage bill
on the basis of the new coefficients and total number of employees.
2

Management and Supervisory Boards to maintain average wages in 2001
at 2000 level, without paying Christmas, vacation, or child bonuses.

Salaries of managers to be set at level not exceeding that for high
government officials (for example, chairmen of management boards not
higher than government ministers).

4. Other government-controlled public enterprises under the supervision
of the CPF (40,000)

Insolvent companies pay only the minimum wage of HRK 1,700 a month,
which will not be raised in 2001, for all their employees.

5. Other enterprises (583,000)

Negotiations on a Social Pact to resume in the first quarter of 2001,
with a proposal from government to hold real wages to somewhat below productivity
increases. Inflation adjustment to be forward looking. Government invitation
for talks to be issued by end-February 2001.1

1Prior action.2Performance criterion.

Annex X

Steps Necessary to Bring at Least 20 Percent of HT's
Shares to the Point of Sale

By end-January 2001

Complete the appraisal of the fixed assets.

By end-February 2001

Submit the new Telecommunications Law to the parliament.

By end-April 2001

Submit the amendments to the HT privatization law to the parliament
with, inter alia, new proposals on the disposition of remaining government
shares.

1 The sharp drop in
the deficit and expenditure ratios in 2003 is partly the result of the expiration
of special pension payments equivalent to 1 percent of GDP.2 Our projections for the consolidated
central government exclude the collection of road tolls from April 2001
and a part of collections from income and profits taxes due to a change
of the revenue sharing formulas with local government from July 2001. As
noted, the road maintenance and construction agency will also benefit from
a new excise of HRK 0.3 per liter of gasoline and diesel. While the
devolution of part of social spending is neutral on the consolidated central
government balance, the transfer of spending on roads to a separate agency
is estimated to improve this balance by 0.6 percent of GDP in 2001, in part
reflecting the fact that foreign-financed road construction was deferred
from 2000 to 2001.3 A cut of 4,000 staff in the Ministry
of Interior has already been decided by the cabinet as the first installment
of the planned overall reduction of 10,000, and most of the remaining cuts
will be effected in the Department of Defense, mostly from its large administrative
staff. The staff reductions will be announced by end-March 2001 and implemented
rapidly on the basis of new, less costly severance pay regulations. Until
then, some wage savings will be realized by furloughing redundant staff
at full pay, but without allowances.4 An agreed multiyear plan to cut employment
in the railroad company (HZ) is already in effect.